Prospects for the UK economy

1
Economics and Business ExchangeSupported by
Deloitte.
2
Monetary Union in EuropeRay Barrell
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Outline and Plan

• Why do we have a Monetary Union in Europe
• The origins of the project and the idea
• The political and economic steps to union
• Why was EMU designed like this
• What is the role of the ECB
• Why do we have a Fiscal Pact
• Has EMU been a success
• What has happened to inflation
• Why has output growth been slow
• What will happen when new members join
• Does it matter that the UK is outside

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The monetary union project

• Plans and discussion for monetary union started
  in the late 1960s and early 1970s
• Early plans were disturbed by events in the early
  1970s and were delayed
• Inflation rates in Europe diverged
• The Exchange Rate Mechanism was set up in 1978 to
  create a converging path to monetary union
• The Maastricht Treaty in 1990 was designed to set
  up the conditions

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The political economy of union

• EMU has been at least as much a political process
  as an economic one
• Germany was the most successful economy in post
  war Europe
• Austria and the Netherlands were in effective
  monetary union with Germany from 1983
• Political pressures fro union came as strongly
  from Netherlands and Belgium as France
• There was a desire for a tight EMU
• Others saw EMU as a way of dealing with their own
  political failings, and Italy and Spain saw it as
  a tool to induce structural change

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Three Dimensions for Policy

• Ensure high levels of output and sustainable
  trajectories for growth
• Low and stable inflation
• High inflation may be related to unstable
  inflation and is often unexpected
• Contracts are hard to design in a world of
  unexpected inflation variability
• Limit the scale of cycles and crises
• Cycles have been becoming more damped
• The risk of financial crises has not fallen

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Enhancing growth and stability

• Output depends on factor inputs and the
  efficiency with which they are used
• Policy should increase supplies of factors
• Increased competition increases efficiency
• The national and international saving and
  investment balance determine real interest rates
• Lower real interest rates increase capital and
  output
• Lower risk premia increase the level of capital
  per unit of output
• Crafts and OMahony show core Europeans have 25
  more capital per head than the UK

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Inflation and Risk

• Lower inflation and output volatility reduces
  risk and affects decision making
• Lower premia mean a lower cost of capital, more
  investment and a higher capital stock
• Higher capital means more output for a given
  level of labour input
• Exchange rate instability increases risk and
  reduces investment and output
• Monetary union membership for the UK may raise
  inflation volatility and will reduce exchange
  rate volatility

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Labour productivity in EU (person hour in ppp)
relative to the US
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Productivity and growth

• Output per person hour is higher in core Europe
  than in the US or the UK
• Over the last 30 years the core Europeans have
  caught up with and overtaken the US
• UK performance has improved marginally recently

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Participation, hours and activity

• Participation rates are lower in core Europe than
  the US or the UK
• Hours are shorter in core Europe
• Methods of constructing the national accounts
  differ significantly
• Core Europe has a lead in output

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The events of the 1970s

• The collapse of Bretton Woods was triggered by a
  German refusal to accept the inflation rate
  determined by US policy
• Outcomes varied across Europe, but German policy
  was much more successful
• Germany kept inflation stable
• The UK and Italy performed badly
• It is not clear that floating exchange rates were
  a success

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Inflation
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The ERM and the path to Union

• Exchange rates became more stable in the 1980s
  with the ERM
• Inflation began to converge but realignments were
  common
• Exchange rates became harder
• Fiscal policy had been loose in the 1980s
• The Maastricht Treaty put constraints on fiscal
  policy
• Deficits were limited
• Debts had a ceiling
• The ERM crisis of 1992 to 93 made the process
  look unstable

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Choosing the members

• In the early 1990s plans involved a small
  membership with tight constraints
• Fiscal constraints were the most important
• Deficits had to be under 3 of GDP
• The debt criteria disappeared
• Exchange rate stability and interest rate
  convergence was required
• These were not always imposed
• Why was a deficit ceiling chosen, and what was
  wrong with the Golden rule

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What is the constitution

• The monetary constitution gives the ECB the right
  to choose its own inflation target
• Is this a democratic deficit
• What are the role of rules
• The background to the ECB must be seen in German
  Ordliberalism (not Mill and utility) where rules
  constrain politicians
• The three pillars of the constitution are price
  stability, competition and the constrained state
  with dispersed responsibility

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EMU and the single market

• The Common Market has always been more than a
  free trade area, and it involved integration of
  standards and rules
• The single market has removed barriers to trade
  and to capital mobility
• It was designed to enhance competition
• Competition reduces rents and raises output
• The first phase increased trade
• The removal of the currency barrier was the last
  step and appears to have increased cross border
  capital mobility

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Fiscal Pacts in EuropeBackground

• Debt stocks rose to high levels by the early
  1990s raising real interest rates
• Debt stocks rose because fiscal policy was
  expected to reduce unemployment
• High unemployment was structural not cyclical and
  fiscal policy did not work
• Lower debt was needed to help reduce real
  interest rates and raise equilibrium output
• Labour market polices were needed to deal with
  structural unemployment

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Why do we need Fiscal Pacts

• Governments need fiscal pacts with their people
  to enhance growth
• The assurance of no excessive borrowing reduces
  expected real interest rates
• Lower borrowing reduces the risk premium
• It lowers the risk of default
• it reduces the pressure for higher inflation to
  be used to reduce the debt burden
• The UK has a Fiscal Pact between the people and
  the state based on the Golden rule
• Does the golden rule have any basis in economic
  theory or it is just a guideline

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Why does EMU need a Pact

• In Monetary Union the gains from fiscal expansion
  are mainly in the home country
• Spillovers are shared by all members
• Increased real interest rates are shared, and in
  the long run reduce output everywhere
• The costs of higher inflation are shared because
  of the pressure of the risk of debt default are
  shared everywhere
• Default risks lie with the country and the
  lenders not the Euro Area

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EMU and monetary target independence

• The ECB has the constitutional remit of
  maintaining price stability
• It started with a range of 0-2 per cent but was
  clear that this was not centred at 1.0
• It now has a target of close to but below 2.0
• How can 2 per cent be price stability
• Why does price stability matter
• Longer term contracts are secure
• Second round effects from oil seem limited
• What are the achievements

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Monetary Policy

• Monetary policy is handled to the ECB
• It has goal and instrument independence
• It is not clear that it is fully effective
• Policy under the Bundesbank was clear
• Behaviour was constant over 25 years,
• Inflation and its volatility were the lowest in
  the G7
• Real exchange rate volatility was low
• ECB behaviour is clearly different
• It appears to have less response to deviations of
  inflation above and below target

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Euro Area Inflation Expectations

• Since oil price began to rise
• US inflation expectations up 0.7 pp on average
  p.a. over next 10 years, and 1 pp over next 5
  years
• Euro Area expectations up just ¼ pp
• Exchange rate developments
• The decline in the dollar raise US inflation
  expectations
• Monetary policy regimes
• The US may be expected to be more accommodating
• Different cyclical positions

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Has EMU been a success?

• We need to judge EMU on growth, stability and
  inflation
• Has inflation been near target
• Has the exchange rate been stable
• Has growth been satisfactory
• We also need to ask what else has been going on,
  and how this affected individual countries ands
  the Union as a whole
• Globalisation and trade agreements
• Technical change and new products

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Inflation performance
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Fiscal policy has the SGP worked
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Why and where has growth been weak

• Growth has been weak in Germany and Italy and
  recently in the Netherlands
• Performance in France has been OK and robust in
  Spain and Finland
• Overall growth has been weak but this may not be
  because EMU has been set up

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Misalignments and the effects of entry

• Overvalued currencies on entry would have caused
  slower growth
• Germany and Italy were overvalued, Netherlands
  and Spain undervalued
• Growth differentials partly reflect adjustment
• Germany controlled policy until 1999, and it was
  designed to reduce volatility there
• EMU will have raised perceived volatility in
  Germany but reduced it elsewhere
• All these should net out leaving growth for EMU
  unchanged

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Technical progress and productivity growth

• Germany has had slow growth in labour
  productivity
• blamed on inflexible labour markets
• Other countries in EMU are similar
• The US has had a wave of technical progress
  raising labour productivity
• The US moved first with new products, and its
  education system and labour market were more
  suited to these developments

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Trade and globalisation

• World trade agreements have changed potential
  output in EMU
• Italy has been badly hit by the ATC because of
  its production structure
• Italy has had very major fiscal consolidation
  over the last decade

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Products and processes

• The world economy has been going through a period
  of product innovation after decades of process
  innovation
• EMU may have slow growth because of the design of
  its institutions
• Long term attachments between firms and workers
  with extensive on the job training are different
  from the US pattern
• EMU styles may be better for process innovation
  and it may be unwise to change
• We may have seen waves of catching up and falling
  behind because of these difference

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Will expansion make EMU more difficult to sustain

• Estonia, Lithuania and Slovenia may join this
  year if inflation and budget deficits allow them
  to do so
• Why are they joining and will it change anything
  in this case not much
• Poland, Czech Republic and Hungary will join by
  2010 Poland is half of NMS
• For given inflation in core Europe they mat raise
  the required inflation target by 0.06 initially
  and 0.2 perhaps in 2010
• These expansions will be easier to manage than
  the inclusion of Italy and Spain at the outset

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Does it matter that the UK is outside EMU

• The SMP and economic integration is not complete
  without UK membership
• The costs to EMU are likely to be small
• The costs to the UK may exist
• It is not clear that the UK will be more stable
  and grow more outside EMU but costs of staying
  outside will be low
• Real exchange rate stability is less likely
  outside and this is the major factor affecting
  investment risk premia

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Conclusion what will happen to EMU

• Exchange rate regimes fall apart slightly more
  often than countries do
• The economic benefits are clear, but the
  political will has to remain
• It is not clear that Italy would find life any
  more comfortable outside EMU, but devaluation and
  inflation can help when you have structural
  problems
• EMU may be a better option than a repetition of
  1933 to 1945

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Economics and Business ExchangeSupported by
Deloitte.